Cliff Diving

As we draw ever closer to the end of the year, speculation grows as to how Congress and the President will address the problem of the fiscal cliff. Last week we wrote about how this combination of tax increases and spending cuts threatens to cast us back into recessionary territory following 13 straight quarters of expansion since the “Great Recession”. We noted that there is no easy solution to this crisis, which has been brought upon us by several decades of profligate spending and government commitments beyond its ability to deliver on those commitments. The day of reckoning is upon us.

This week, thanks to the hard work of the people at the Congressional Budget Office, we put some numbers to the fiscal cliff. Recent studies by the CBO suggest that the failure to avert the automatic tax hikes and spending cuts before year end will indeed result in an economic recession in 2013. By CBO’s estimate, GDP would contract 0.5% from the fourth quarter of 2012 to the fourth quarter of 2013 if nothing were to be done. On the other hand, if Congress were able to reach an agreement whereby all the automatic tax hikes and spending cuts could be put off (again), the CBO believes that the economy could potentially grow as much as 2.4% next year. This growth rate assumes that ALL the negative effects of the fiscal cliff are deferred. Nobody believes this will happen. A more likely scenario, according to most pundits, is that Congress may allow some elements of the fiscal cliff to go ahead as scheduled, such as the expiration of payroll tax cuts and emergency employment benefits. Any Congressional agreement would involve the other elements of the fiscal cliff, including the Bush-era tax cuts, an Alternative Minimum Tax patch, and the automatic spending cuts established by the Budget Control Act of 2011. Under such an agreement, the CBO projects that GDP will grow 1.7% next year and that the unemployment rate will be 8.0% at the end of 2013 – nothing to celebrate, but a heck of a lot better than another recession.

Given that stocks drop greater than 25% on average in a recession (and sometime far greater), it is easy to see that this exercise is not a trivial one for investors. If you were highly confident that a deal will not get done to avert any of the elements of the fiscal cliff, you would probably sell all your stocks now and avoid the usual weakness associated with recessions. However, we do not believe it so simple. If we indeed do go off the fiscal cliff and end up in recession, there will undoubtedly be longer-term positives as well as the short-term negatives associated with this course of action. One of the market’s biggest concerns in recent years has been the US government’s failure to address its long-term structural deficits, which are largely the result of an explosion in entitlement spending on baby boomers. If the country’s long-term fiscal situation is suddenly put on firmer ground, this might actually be a positive for our longer-term growth prospects and therefore stocks as well.

It is also important to note that the CBO’s economic projections are completely focused on the US. Given that over 40% of S&P 500 earnings are derived outside the US (estimates vary and fluctuate), an astute investor must consider the growth outlook in Europe, Japan, China and other emerging markets as well. As it now stands, Europe is a mess, Japan isn’t too much better, and growth prospects in China ebb and flow based largely on government intervention. Is a plunge off the fiscal cliff in the US likely to change the outlook in any of these regions? Can a case be made that more rapid deleveraging across the globe is actually good for longer-term global growth prospects?

I guess my point is that nobody knows for sure what will happen. Nobody knows if we will go over the fiscal cliff, to what extent, and how the plunge will affect the global economy and stocks over both the short and long term. Therefore, our advice is to stay the course and remain invested. It is exceedingly difficult to predict short-term market moves with any degree of consistency or precision. Valuations for high quality and defensive blue chip stocks are very reasonable, especially relative to the yields available on bonds. In the words of Joe Rosenberg, Chief Investment Strategist at Loew’s, “You can have cheap equity prices or good news, but you can’t have both at the same time.” So let the roller coaster take its turns and try not to obsess about what could go wrong.

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